Sunday, March 25, 2012

I'd like to expand on my last post about home solar panels (which I think has important points I don't hear being made). There's something very different and important about home solar panels compared to the typical advancement that increases GDP.

Long ago I came to the realization that not all $10 trillions in GDP are the same. You could have two countries (or separate worlds): One has $10 trillion in GDP, but $7 trillion in yachts, mansions, super-luxury resorts and restaurants, etc., vast income inequality, and $0.5 trillion in high return investments like basic science, education, and smart infrastructure. The other has the same $10 trillion in GDP, but is far less unequal, and has ten times the high return investment, $5 trillion.

That second country (or planet, to preclude the issue of free riding on technological advance), even though it has the same $10 trillion in GDP, could have much higher total societal utils today, and at the same time, in 50 years will be far wealthier – ridiculously wealthier a century later. After all, $5,000 meals and 50,000 square foot homes don't do much to advance science and productivity. And even the most extreme libertarian economists haven't yet had the gall to claim that marginal utility doesn't diminish greatly with increased consumption. And don't even get me started on positionalexternalities.

Remember, economists love to talk about Pareto optimality, but when you draw your Edgeworth Box in micro, with your curvy line containing all of the Pareto Optimal allocations, some of them have vastly more total societal utils than others. And it really shows the right wing bias in economics that the focus is almost exclusively on Pareto efficiency as opposed to maximizing total societal utils efficiency.

So not all $10 trillions in GDP are the same, and not all $X increases in GDP are the same. Take home solar panels, suppose that in 20 years 100 million American homes will have solar panels (not to mention solar walls and windows) that generate an average of $5,000/year in power. That's $500 billion more in GDP (Let's assume the panels are already installed, and they last 50+ years with little maintenance; see my last post for details and cites). But as we've painfully seen, an increase in GDP of a half-trillion can go almost all to the rich, or super rich, and do very little to add to total societal utils.

But there's more than that; In finance were always talking about states of the world, state-dependent utility, and how investments that pay off in bad states are much more valuable than those that pay off in good ones, even if they have identical expected payoffs. So even an extra half-trillion that went to the middle class and poor would still be a lot less increasing of expected utils if it was: in good times you get a nice windfall on top, and in bad times you get little or nothing.

Instead, what would really increase expected utility for the middle class and poor is an expected half trillion that paid off just as well in bad times, when you really need it (or really really need it), as in good times. In other words, a safety net. And that's just what solar panels are, a new and important safety net for the middle class and poor. If you lose your job, and have to support a family on very meager unemployment, it really helps if you have solar panels (and maybe walls and windows too) that make it so you have no utilities bill, and with potential increases in efficiency over the next 20-30 years -- both in the panels and the things they power -- no fuel bill (the panels power your electric cars), and no property taxes and insurance (with those potentially paid for by selling solar power back to the grid).

If Obamacare survives for try-and-see to decimate the disinformation (and outright lies), this gives people the opportunity, with a paid off home (an important focus in good personal finance), to always have a home, health care, utilities, and fuel, even in the worst of times. So that they can get by on just unemployment (and maybe food stamps and other aid), without financial ruin for their families, and maybe foreclosure, or worse -- shamefully, homeless families aren't that rare today. This would be a fantastic safety net to have commonly available with how profoundly risky our country has become over the last generation (see Yale political scientist Jacob Hacker's 2007 book The Great Risk Shift for details).

So far I've talked about how home solar panels represent a potentially large increase in GDP that (1) is for the 99%, not just the 1%, or 0.1% (or 0.01%), and (2) is a safety net that's there when you need it most, in, as finance academics would say, bad states. Next I'd like to add, (3) solar panels are (more or less) a non-positional good.

Suppose $5,000 per year was added to the GDP for every household, but it was in car spending. So every five years families spent $25,000 extra on their cars. So you go from a Honda to an Acura. Well, I think the vast majority of readers will see (or admit) that you get a lot less utility out of an Acura if everyone has an Acura, and it's just a normal car now. And in fact, if everyone is getting Acuras, or otherwise spending $25,000 extra on their cars, and you aren't, then you're going to be the poor guy with the cheap-ass car. And unless you’re a freshwater economist with a strong libertarian agenda, you'll probably admit, at least to yourself, that this will cause you substantial disutility (at least to your love life -- but that's positional too).

So positional externalities are very real and very large (for the formal evidence see here). They're an important reason why countries much poorer than the US have as high, or higher, happiness in surveys and studies. When everyone buys a fancier car a lot of the utiltiy goes up in the smoke of positional externalities, as the car is no longer fancy. Same for clothes, homes, and so much else that we buy. But solar panels, and the electricity and fuel they generate, aren't very positional, especially once the novelty wares off. So the utiltiy you get from them doesn't go down by much when you go from being one of the only guys in the neighborhood with them, to everyone has them. Bottom line: $5,000 added to everyone in a non-positional good will add much more total societal utils than $5,000 added to everyone in positional goods.

And I'll add a (4) here. Home solar panels create profound positive externalites in that they help insure against catastrophic global warming and starve funds from some of the worst authoritarian and terrorist sponsoring regimes in the world. And without petro-money, these regimes are in serious trouble, and face great pressure to change for the better, or starve and be overthrown. In fact, there's a strong correlation between reform (and backsliding) in these countries and the price of oil.

So home solar panels really are different and rare in how they add to GDP: (1) They’re for the 99%, not just the 1% (or a lot less), (2) They're an important new safety net, (3) They're non-positional, and (4) They have profound positive externalites.

Sunday, March 18, 2012

An interesting and important aspect of home solar panels is their unique investment and personal finance properties. In some ways they're a rare very low risk investment.

A cornerstone of finance is the risk-expected return tradeoff. The lower the risk of an investment, the lower an expected return it makes sense to settle for. And if the asset is negative risk (it lowers your current total risk), like insurance, then it can even make sense to accept a negative expected return. And people do that all the time when they buy fire insurance. A great example, too, though too few even economists seem to realize it, is global warming insurance.

With solar, you have an investment that can really lower a family's risk. And today's America is amazingly risky for most families (see Yale political scientist Jacob Hacker's book, The Great Risk Shift). A job loss can all too quickly and easily lead to ruin for a family, as unemployment insurance pays very little. A great defense is to have your house paid in full, and I usually advise a 15 year mortgage (when it does makes sense to buy), and even then, paying it off faster. But you still have utilities, property taxes, insurance, etc.

If you solar up your house, especially in a state like mine, Arizona, this means little or no utility bill, and eventually the panels may generate enough electricity to also mean no fuel bill (with electric cars). And even no property tax bill! Why? It's already common in Arizona to have backwards running meters to sell back excess power from solar panels (and it was offered in 43 other states in 2010), so the money you make from your home power plant can cover your property taxes. This, of course, depends on how many panels you have on your roof (and the rest of your property, solar gazebos!), what state you live in (not everyone lives in solar ground zero, Arizona), things like how southern facing your panels are, and the ever increasing efficiency of the panels.

Few people, even in Arizona, may generate the kind of power that covers your utilities, fuel, and property taxes today. But in 20 years, the power capturing ability of panels may double or quadruple (see, for example, here, here, and here). We can also expect big advancements in energy efficiency in our homes, appliances, and electric vehicles, also contributing to solar panels providing much more. And if solar starts providing these kinds of financial benefits, believe me, you're going to see a whole lot more people moving from cold states to Arizona, Nevada, etc. (more on this below). And panels are going to be put in a lot more places than just the southern facing part of the roof, along with perhaps other solar power capturing devices like special windows and walls.

Elizabeth Warren has what I think is the best personal finance book available today, "All Your Worth". In it she really stresses -- above all else -- the importance of keeping your "Must-Haves" (fixed expenses) low to withstand today's risky world. Solar is a very nice addition in this respect. The panels are typically guaranteed for 25 years, and may last much longer. And there are potential advancements that can extend lifespan, maybe greatly (see, for example, here and here).

Of course, you could just take the money you were going to put into solar and put it into some other very safe asset, like TIPS, but:

(2) If you have the money in solar panels instead, it may not be touchable in bankruptcy, or by creditors or litigants in general. Many states protect your home, including additions, (homestead exemption), up to a large, or unlimited, amount. It definitely adds to your family's badly needed security knowing that no matter how bad things get, you can never lose your home, or your free electricity, fuel, and maybe regular supplemental income from your panels. Creditors and litigants can take your TIPS, but in many states they can't take your home, or your panels.

(3) When applying for college financial aid, often your home equity, including solar panels, is not considered. But I can guarantee you a hunk of money in TIPS is (unless perhaps it's in an IRA or 401k, but the panels should be on top of maxing your IRA and 401k contribution limits). The same is true of some government assistance and other need-based programs.

(4) The solar return can be really good, way better than TIPS. From what I've heard, a 7 year payback, or less, is not that rare already in Arizona. (yes, I know very well after years in finance, that NPV is the ultimate, but payback period can help you estimate NPV, because all other things equal, a shorter payback period means a less risky, less uncertain, project. So knowing the payback period helps you make a better decision on the discount rate to use.) The payback period depends a lot on the tax spiffs, and those can vary a lot by state. So interestingly, this study, found a shorter payback period in Massachusetts than Arizona.

(5) Solar Panels protect you against inflation too, and maybe a lot better than TIPS do. With TIPS, you get compensated for changes in the price of the CPI basket, but your purchases may be very different from the CPI basket. And if your family is in a financial crisis, you're not going to be purchasing much of the discretionary or luxury items that are in the basket, but electricity and fuel will be very important. A spike in their prices could really hurt you during a family financial crisis. It's very risk-decreasing knowing those things will always be free, or small, if you have to ride out a crisis.

In 20 years, if Obamacare survives for try-and-see to decimate the disinformation, it could be common for people to always have health insurance, power, and fuel for their cars that they can never lose, and maybe substantial supplemental income from selling solar power on top. This would certainly be a welcome huge step forward in families' security.

On a related note, I think in 20 years Arizona could really be hot -- in more ways than one. Advanced, powerful, and inexpensive panels (and other solar collecting devices like special windows and walls) could really make it relatively cheap to live there, with free utilities and fuel, and with selling the excess back to the grid free property taxes, homeowners insurance, and maybe more, the way the generation of these panels keeps increasing. I always tell my wife I want to turn our backyard into a solar plant! Gazebos with panels on top! She's not thrilled with the idea.

It is hard [microfoundations modeling] because these models need to be internally consistent. If we think that, say, consumption in the real world shows more inertia than in the baseline intertemporal model, we cannot just add some lags into the aggregate consumption function. Instead we need to think about what microeconomic phenomena might generate that inertia. We need to rework all relevant optimisation problems adding in this new ingredient. Many other aggregate relationships besides the consumption function could change as a result. When we do this, we might find that although our new idea does the trick for consumption, it leads to implausible behaviour elsewhere, and so we need to go back to the drawing board. This internal consistency criteria is partly what gives these models their strength.

It is hard then, in part, because you are trying to fit a square peg into a round hole. You're trying to fit perfect optimizing behavior of individuals ("internal consistency") to the behavior of aggregates that did NOT, in fact, result from perfect optimizing behavior of individuals. They resulted from very imperfect optimization of very imperfect individuals, with very limited expertise, information, time for analysis, and self-discipline, to name a few (and I can tell you first hand, as a businessman and family man, that with how busy and distracted people are, it can take them a while to analyze and react, even with their imperfect public knowledge, analysis, and reaction).

Here's Simon again:

It took many years for macroeconomists to develop theories of price rigidity in which all agents maximised and expectations were rational…

Again, square peg, round hole. It's very hard to find a model where every single person has perfect maximization and perfect rational expectations, and you still get, at least qualitatively, the type of aggregate behavior we see in the real world, because that aggregate behavior we see in the real world is not generated from individuals who all have perfect maximization and perfect rational expectations, not even close for many things.

If, on the other hand, you're just modeling the behavior of the aggregate based on how we have actually seen it behave, not some ideal, this gives you an advantage in creating a more realistic model that can better predict, and be used to study the effects of policy. It's not without problems though, even though it has important advantages:

-- We sometimes don't have a great deal of relevant historical data to model the aggregates on.

-- There can be substantial regime change, so that past history of the aggregate(s) is not very representative, or relevant, to the present (Of course, you should look for enduring features of the aggregate(s) that survive regime shifts.)

So, like in the physical sciences (Noah gives the example of meteorology), it's best to study and model both the micro units and the aggregates as a whole.

And, it would be nice if our microfoundations models could make more realistic assumptions about the knowledge, expertise, education, self-discipline, and other behavioral factors of the micro units, i.e. people. I know this can make it very hard, or intractable, to solve the model in closed form, but why not just have it be a computer simulation, to test things with a very complicated, and mathematically and global-optimizationally intractable, but much more realistic model? That could be extremely useful.

Sunday, March 4, 2012

In the recent round of criticisms of microfoundations modeling (see, for example, here, here, and here), there's an important criticsim that I haven't seen really hit directly: If you're going to start out micro and aggregate up to a very complicated reality, then it's very hard (at least) to do without making extremely strong, simplifying, and unrealistic assumptions, and that's where the microfondations models can be very unrealistic, and bad for understanding, predicting, and policy.

This issue is in finance too. One of the biggest, and certainly loudest, critics of microfounded finance models is Robert Haugen. Haugen now runs an investment services firm, but he was previously a finance professor at University of California, Irvine, and is #17 on a publications' prestige weighted list of finance's most prolific authors, 1959 -- 2008.

Haugen's criticism is that the aggregate of very complicated, highly interacted, micro behavior can be better understood if you just observe the behavior of that aggregate, rather than trying to understand it, predict it, and make good policy from modeling micro unit behavior and then aggregating up.

In finance, then, you can understand and model the behavior of financial asset markets just by looking at how those markets behave over time, and creating a model to fit that observed behavior. This will get you a much more accurate, realistic, and useful model, than if you make very simplifying assumptions about individual behavior and interaction so that it's tractable to aggregate up to the market as a whole.

So in other words, a model of aggregates can be much more realistic and accurate in describing the behavior of those aggregates because you aren't forced to make extremely unrealistic simplifying assumptions about micro units in order to make aggregating them tractable.

In Haugen's own words:

Chaos aficionados sometimes use the example of smoke from a cigarette rising from an ashtray. The smoke rises in an orderly and predictable fashion in the first few inches. Then the individual particles, each unique, begin to interact. The interactions become important. Order turns to complexity. Complexity turns to chaotic turbulence... ("The New Finance", 2004, 3rd Edition, page 122)

How then to understand and predict the behavior of an interactive system of traders and their agents?

Not by taking a micro approach, where you focus on the behaviors of individual agents, assume uniformity in their behaviors, and mathematically calculate the collective outcome of these behaviors.

Aggregation will take you nowhere.

Instead take a macro approach. Observe the outcomes of the interaction – market-pricing behaviors. Search for tendencies after the dynamics of the interactions play themselves out.

View, understand, and then predict the behavior of the macro environment, rather than attempting to go from assumptions about micro to predictions about macro... (page 123)

Now you may reply, Lucas critique! But, as is a theme of this post, let's be realistic. The Lucas critique in many cases relies on people having a ridiculous amount of knowledge, expertise, free time (or little value for the time they must spend analyzing economic, political, and governmental policy, something that few people get much enjoyment from), and self-discipline to have much effect. Sometimes the Lucas effect may be very weak (or slow).

Take a look at surveys of people's knowledge of the governments' budgets and then tell me that it's common for people to accurately, precisely, and regularly adjust their consumption to expected changes in government spending.

In the words of Paul Krugman:

Does this argument sound convincing? It did (and still does) to many economists. Akerloff pointed out, however, that it depends critically on the assumption that people do something that they are unlikely to do in real life: take account of the implications of current government spending for their future tax liabilities. That is, the claim that deficits don't matter implicitly assumes that ordinary families sit around the dinner table and say, "I read in the paper that President Clinton plans to spend $150 billion on infrastructure over the next five years; he's going to have to raise taxes to pay for that, even though he says he won't, so we're going to have to reduce our monthly budget by $12.36."

...the truth is that even families of brilliant economists don't have conversations like this. No, the point is that the effort isn't worth it. If a family has arrived at a sensible rule of thumb for deciding how much to spend, trying to improve on that rule by making sophisticated predictions about the future implications of government spending will improve the families decisions so little that it isn't worth the investment of time and attention.

"Richard Serlin, who has made himself one of the world’s experts on Neil Wallace’s original paper, was good enough to agree to write a guest post..." – Miles Kimball, University of Michigan economist, and one of the founders of New Keynesian Economics

"Richard Serlin (HT Mark Thoma) gives the bottom line intuition of Wallace neutrality... " – Bruegal blog, EU economics think tank, considered one of the best in the world

About Me

I am an adjunct professor for the University of Arizona where I teach one of the largest personal finance courses in the country, with over 500 students per year. I hold an MBA from the University of Michigan and have completed all coursework and written exams for a Ph.D. in finance from the University of Arizona. I am also president and co-founder of Summit Personal Finance Education, one of the country's largest U.S. Trustees approved providers of a personal finance course, designed by myself, which meets the requirements for bankruptcy filers under the BAPCPA law of 2005.

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I edit and improve most of my posts after I initially place them. I will not hesitate to do this, and without cross-outs, as my main goal is to teach and discuss clearly and well, to help with understanding and good idea creation, not to leave a historically accurate evolution of my writing. In fact, if you think the writing of a post has clunky spots or mistakes, you might want to try looking at it hours or days later. These things may be fixed, plus valuable new material may have been added. My writing really tends to improve with seasoning.

I will, however, note if I have made a major change of opinion, or corrected an important mistake of fact that could be substantially harmful to a person or party. This is subject to interpretation, however. For example, if the post was up for two minutes before I fixed it, I may not write a correction note. Unless my blog traffic greatly increases, it's unlikely many people, or any people, saw it.